Financial Statement

Analysis

GROUP 2 REPORT
 OBJECTIVES
1. Understand the purpose of basic financial statements and their contents.
2. Explain the importance of financial statement analysis to the firm and to outside
suppliers of capital.
3. Define, calculate, categorize, and interpret the major financial ratios.
4. Define, calculate, and discuss a firm’s operating cycle and cash cycle.
5. Use ratios to analyze a firm's health and to give recommendation.
6. Analyze a firm’s return on investment and return on equity.
7. Understand the limitations of financial ratio analysis.
8. Use trend analysis, common-size analysis, and index analysis to gain additional
insights into a firm's performance.
Examples of External Uses of
Statement Analysis
• Trade Creditors – Focus on the liquidity of the
firm.
• Bondholders – Focus on the long-term cash
flow of the firm.
• Shareholders – Focus on the profitability and
long-term health of the firm.
 Examples of Internal Uses of
Statement Analysis
• Plan – Focus on assessing the current
financial position and evaluating potential
firm opportunities.
• Control – Focus on return on investment for
various assets and asset efficiency.
• Understand – Focus on understanding how
suppliers of funds analyze the firm.
 Primary Types of Financial
Statements
Balance Sheet
• A summary of a firm’s financial position on
a given date that shows total assets = total
liabilities + owners’ equity.
Income Statement
• A summary of a firm’s revenues and expenses
over a specified period, ending with net income
or loss for the period.
ALDINE MANUFACTURING COMPANY BALANCE SHEETS (THOUSANDS)
AS OF MARCH 31, 20X2, AND MARCH 31, 20X1 1
ALDINE MANUFACTURING COMPANY INCOME STATEMENTS (THOUSANDS)
FOR THE FISCAL YEARS ENDING MARCH 31, 20X2, AND MARCH 31, 20X1 1
Use of Financial Ratios

A Financial Ratio is an Types of

index that relates two Comparisons
accounting numbers
and is obtained by Internal
dividing one number Comparisons
by the other. External
Comparisons
 External Comparisons and
Sources of Industry Ratios
This involves comparing Examples:
the ratios of one firm with
Risk Management
those of similar firms or
Association
with industry averages.
Dun & Bradstreet
Similarity is important as Almanac of
one should compare Business and
“apples to apples.” Industrial Financial
Ratios
Liquidity Ratios
QUICK RATIO CURRENT RATIO
Quick Assets _ Current Assets _
Current Liabilities Current Liabilities

Quick assets : Current assets :

 Cash and cash equivalents  Cash and cash equivalents
 Marketable securities  Marketable securities
 Trade Accounts receivable  Trade Accounts receivable
 Inventories

Current Liabilities:
 Trade Accounts Payable
 Accrued Liabilities
 Short-term Loans
Debt to Equity Ratios
A measure of a company's financial leverage calculated by dividing its
total liabilities by stockholders' equity.

It indicates what proportion of equity and debt the company is using

to finance its assets.
Sample
problems

1. Which of the following is considered a profitability

measure?

A. Days sales in inventory

B. Fixed asset turnover
C. Price-earnings ratio
D. Cash coverage ratio
E. Return on Assets

ANSWER : E
Firm A has a Return on Equity (ROE) equal to 24%, while firm
B has an ROE of 15% during the same year. Both firms have
a total debt ratio (D/V) equal to 0.8. Firm A has an asset
turnover ratio of 0.9, while firm B has an asset turnover ratio
equal to 0.4. From this we know that

A. Firm A has a higher profit margin than firm B

B. Firm B has a higher profit margin than firm A
C. Firm A and B have the same profit margin
D. Firm A has a higher equity multiplier than firm B
E. You need more information to say anything about the
firm's profit margin

ANSWER : B
If a firm has $100 in inventories, a current ratio equal to
1.2, and a quick ratio equal to 1.1, what is the firm's Net
Working Capital?

A. $0
B. $100
C. $200
D. $1,000
E. $1,200

ANSWER : C
To measure a firm's solvency as completely as possible, we
need to consider

A. The firm's relative proportion of debt and equity in its capital

structure
B. The firm's capital structure and the liquidity of its current
assets
C. The firm's ability to use Net Working Capital to pay off its
current liabilities
D. The firms leverage and its ability to make interest payments
on its long-term debt
E. The firm leverage and its ability to turn its assets over into
sales

ANSWER : D
Required:
1.) Compute Quick Ratio
and Current Ratio
2.) Interpret
ANSWERS
 Coverage Ratios

Income Statement Interest Coverage

Ratios
EBIT
Interest Charges
Coverage Ratios
For Basket Wonders
Indicates a firm’s ability December 31, 2007
to cover interest
charges. $210 = 3.56
$59
Coverage
Ratio Comparisons
Interest Coverage Ratio
Year BW Industry
2007 3.56 5.19
2006 4.35 5.02
2005 10.30 4.66
BW has below average interest coverage
relative to the industry average.
 Activity Ratios

Income Statement/ Receivable Turnover

(Assume all sales are credit sales.)
Balance Sheet
Ratios
Activity Ratios
Indicates quality of
receivables and how
successful the firm is in its
collections.
Annual Net Credit Sales
Receivables
For Basket Wonders
December 31, 2007
$2,211 = 5.61
$394
Activity Ratios

Income Statement/ Avg Collection Period

Balance Sheet
Ratios Days in the Year
Receivable Turnover

Activity Ratios For Basket Wonders

December 31, 2007
Average number of days
that receivables are
outstanding. 365 = 65 days
(or RT in days) 5.61
Activity
Ratio Comparisons
Average Collection Period
Year BW Industry
2007 65.0 65.7
2006 71.1 66.3
2005 83.6 69.2
BW has improved the average collection
period to that of the industry average.
 Activity Ratios

Income Statement/ Payable Turnover (PT)

(Assume annual credit
Balance Sheet purchases = $1,551.)
Ratios
Annual Credit Purchases
Accounts Payable
Activity Ratios

Indicates the promptness For Basket Wonders

of payment to suppliers by December 31, 2007
the firm. $1551
= 16.5
$94
Activity Ratios

Income Statement/ PT in Days

Balance Sheet
Ratios Days in the Year
Payable Turnover
Activity Ratios
For Basket Wonders
December 31, 2007
Average number of days
that payables are 365
outstanding. = 22.1 days
16.5
Activity
Ratio Comparisons
Payable Turnover in Days
Year BW Industry
2007 22.1 46.7
2006 25.4 51.1
2005 43.5 48.5
BW has improved the PT in Days.
Is this good?
 Activity Ratios

Income Statement/ Inventory Turnover

Balance Sheet
Ratios Cost of Goods Sold
Inventory
Activity Ratios
For Basket Wonders
Indicates the effectiveness December 31, 2007
of the inventory
management practices of $1,599 = 2.30
the firm. $696
 Activity
Ratio Comparisons
Inventory Turnover Ratio
Year BW Industry
2007 2.30 3.45
2006 2.44 3.76
2005 2.64 3.69
BW has a very poor inventory turnover ratio.
 Activity Ratios

Income Statement/ Total Asset Turnover

Balance Sheet
Ratios Net Sales
Total Assets
Activity Ratios
For Basket Wonders
Indicates the overall December 31, 2007
effectiveness of the firm in
utilizing its assets to $2,211 = 1.02
generate sales. $2,169
 Activity
Ratio Comparisons
Total Asset Turnover Ratio
Year BW Industry
2007 1.02 1.17
2006 1.03 1.14
2005 1.01 1.13
BW has a weak total asset turnover ratio.
Why is this ratio considered weak?
 Profitability Ratios

Income Statement/ Gross Profit Margin

Balance Sheet
Ratios Gross Profit
Net Sales
Profitability Ratios
For Basket Wonders
December 31, 2007
Indicates the efficiency of
operations and firm pricing $612 = 0.277
policies. $2,211
Profitability
Ratio Comparisons
Gross Profit Margin
Year BW Industry
2007 27.7% 31.1%
2006 28.7 30.8
2005 31.3 27.6

BW has a weak Gross Profit Margin.

 Profitability Ratios

Income Statement/ Net Profit Margin

Balance Sheet
Ratios Net Profit after Taxes
Net Sales
Profitability Ratios
For Basket Wonders
Indicates the firm’s December 31, 2007
profitability after taking
$91 = 0.041
account of all expenses
$2,211
and income taxes.
Profitability
Ratio Comparisons
Net Profit Margin
Year BW Industry
2007 4.1% 8.2%
2006 4.9 8.1
2005 9.0 7.6

BW has a poor Net Profit Margin.

 Profitability Ratios

Income Statement/ Return on Investment

Balance Sheet
Ratios Net Profit after Taxes
Total Assets
Profitability Ratios
For Basket Wonders
Indicates the profitability on December 31, 2007
the assets of the firm (after
all expenses and taxes). $91 = 0.042
$2,160
Profitability
Ratio Comparisons
Return on Investment
Year BW Industry
2007 4.2% 9.6%
2006 5.0 9.1
2005 9.1 10.8

BW has a poor Return on Investment.

 Profitability Ratios
Income Statement/
Balance Sheet
Ratios
Profitability Ratios
Indicates the profitability to
the shareholders of the firm
(after all expenses and
taxes).
Return on Equity
Net Profit after Taxes
Shareholders’ Equity
For Basket Wonders
December 31, 2007
$91 = 0.08
$1,139
Profitability
Ratio Comparisons
Return on Equity
Year BW Industry
2007 8.0% 18.0%
2006 9.4 17.2
2005 16.6 20.4

BW has a poor Return on Equity.

 Return on Investment and
the Du Pont Approach
Earning Power = Sales profitability ×
Asset efficiency
ROI = Net profit margin ×
Total asset turnover
ROI2007 = 0.041 × 1.02 = 0.042 or 4.2%
ROIIndustry = 0.082 × 1.17 = 0.096 or 9.6%
(Note: values are rounded)
 Return on Equity and
the Du Pont Approach
Return On Equity = Net profit margin X
Total asset turnover X
Equity Multiplier
Total Assets
Equity Multiplier =
Shareholders’ Equity
ROE2007 = 0.041 × 1.02 × 1.90 = 0.080
ROEIndustry = 0.082 × 1.17 × 1.88 = 0.180
(Note: values are rounded)
 GROWTH RATIOS

Income Statement/
 Growth Ratio


 Balance Sheet
(Value of t+1) – (Value of t)
 Ratios (Value of t)
x100
Growth Ratios For Basket Wonders
December 31, 2007
Indicates the firm’s
growth of any activities
STOCK RATIOS

Earning / Share = (EPS)=

Net Profit / # of Shares
= 91,000 / 200,000
=0.455
STOCK RATIOS

Dividends/Share

(Div.)= Distributed profit / # of

Shares
38,000 / 200,000 = 0.19
 STOCK RATIOS

 Price Earning Ratio

 (Profit Multiplier)

 (PE)= Market Price/ Earning/Share

 = 6.00 / 0.455= 13.19

 OR = 8.00 / 0.455 = 17.58
STOCK RATIOS

Book Value= Shareholders’

Equity / # of Common Shares
= 1,139,000 / 200,000

= 5.695
STOCK RATIOS

 Market Price to Book Value

 = Market Price / Book Value

 = 6.00 / 5.695 = 1.05

 OR = 8.00 / 5.695 = 1.40
STOCK RATIOS

The Paid Price = 200,000 +

729,000 = 929,000
The Paid Price / Share =
929,000 / 200,000 = 4.645
 TREND ANALYSIS

1. A tool in the business and financial sectors that uses

current and historical data as a guide for decision
making.
2. Trend analysis is often used to make projections and
assessments of financial health.
3. Financial analysts examine the past performance of
their company, along with current financial conditions,
to determine how their company will perform in the
future.
Liquidity Ratio Trend vs Activity Trend
Liquidity Ratio Trend

Activity Trend
 Summary of Trend Analyses

• Aldine’s current ratio and acid test ratio had

declined over time but still exceed industry
average.
• Average collection period and inventory turnover
have grown and exceeds industry norm. Which
implies a buildup in receivables and inventories.
• Despite above average liquidity ratios, the
sluggish receivables and inventory is a matter of
concern that needs to be investigated in depth.
Profitability Trends
Profit Margin

Activity Trend
Summary of Trend Analyses

• Aldine’s gross profit margin and net profit margin

are stronger than the typical industry level.
• ROI has been relatively stable over time, but
below industry standard.
• ROE has improved over the recent past at a level
below industry standard.
• Overall, the positive effect of above-average
sales profitability was dampened by the sluggish
asset turnover over time.
Common-Size Analysis

An analysis of percentage financial

statements where all balance sheet
items are divided by total assets and all
income statement items are divided by
net sales or revenues.
R.B Harvey Electronics Company Balance
Sheets
(at December 31)
R.B Harvey Electronics Company Balance
Sheets
(at December 31)
R.B Harvey Electronics Company Income
Statements
(for years ending December 31)
Index Analyses

An analysis of percentage financial statements

where all balance sheet or income statement
figures for a base year equal 100.0 (percent)
and subsequent financial statement items are
expressed as percentages of their values in
the base year.
R.B Harvey Electronics Company
Balance Sheets
(at December 31)
R.B Harvey Electronics Company
Balance Sheets
(at December 31)
R.B Harvey Electronics Company
Income Statements
(for years ending December 31)
Summary of Key Ratios
Summary of Key Ratios
Summary of Key Ratios
 69

STATEMENT OF CASH FLOWS

 Reports the entity’s cash flows (cash receipts

and cash payments) during the period
 70

PURPOSES OF THE STATEMENT

OF CASH FLOWS
1. Predict future cash flows
2. Evaluate management decisions
3. Determine the ability to pay dividends to
stockholders’ and payments to creditors
4. Show the relationship of net income to
the business’s cash flows
 71

WHAT IS CASH?

 Cash on hand
 Cash in the bank

 Cash equivalents - highly liquid, short-

term investments that can be converted
into cash with little delay
 Money-market investments
 U.S. Government Treasury bills
 72

THE SOURCES AND USES OF CORPORATE CASH

Sources Uses

 Decrease in any asset  Increase in any asset

 Increase in any liability
 Net profits after taxes
 Depreciation and other
non-cash charges
 Sale of stock
 Decrease in any liability
 Net loss
 Dividends paid
 Repurchase or retirement
of stock
 73

OPERATING, INVESTING, AND FINANCING

ACTIVITIES
 Operating activities create revenues, expenses,
gains, and losses.
 Investing activities increase and decrease long-
term assets.
 Financing activities obtain cash from investors
and creditors.
 74

TWO FORMATS FOR

OPERATING ACTIVITIES
 Indirect method reconciles from net
income to net cash provided by operating
activities
 Direct method reports all cash receipts
and cash payments from operating
activities
 The two methods have no effect on
investing or financing activities.
TWO FORMATS FOR
OPERATING ACTIVITIES
Indirect Method
Net income $XX
Adjustments:
Depreciation, etc. XXX
Net income provided by operating activities $XX
Direct Method
Collection from customers $XXX
Deductions:
Payment to suppliers, etc. XXX
Net income provided by operating activities $XX
PRESENTATIONAL CHOICES
 Interest paid can be classified under either operating
or financing activities
 Interest and dividends received can be included in
either operating or investing cash flows
 Starting from net profit or operating profit under the
indirect method (with implications for the adjustments
to be made)
IAS 7 - DIRECT METHOD (EXTRACT)
20X2
Cash flows from operating activities
Cash receipts from customers 30,150
Cash paid to suppliers and employees (27,600)
Cash generated from operations 2,550
Interest paid (270)
Income taxes paid (900)

Net cash from operating activities 1,380

Cash flows from investing activities

Acquisition of subsidiary X, net of cash acquired (550)
Purchase of property, plant and equipment (350)
Proceeds from sale of equipment 20
Interest received 200
Dividends received 200

Net cash used in investing activities (480)

Cash flows from financing activities

Proceeds from issue of share capital 250
Proceeds from long-term borrowings 250
Payment of finance lease liabilities (90)
Dividends paid* (1,200)

Net cash used in financing activities (790)

Net increase in cash and cash equivalents 110

Cash and cash equivalents at beginning of period 120
Cash and cash equivalents at end of period 230
Source: IAS 7 – Cash Flow Statements, Appendices
* This could also be shown as an operating cash flow.
IAS 7 - DIRECT METHOD (EXTRACT)
20X2
Cash flows from operating activities
Cash receipts from customers 30,150
Cash paid to suppliers and employees (27,600)
Cash generated from operations 2,550
Interest paid (270)
Income taxes paid (900)

Net cash from operating activities 1,380

Cash flows from investing activities

Acquisition of subsidiary X, net of cash acquired (550)
Purchase of property, plant and equipment (350)
Proceeds from sale of equipment 20
Interest received 200
Dividends received 200

Net cash used in investing activities (480)

Source: IAS 7 – Cash Flow Statements, Appendices

IAS 7 - DIRECT METHOD (EXTRACT- CONT.)

Cash flows from financing activities

Proceeds from issue of share capital 250
Proceeds from long-term borrowings 250
Payment of finance lease liabilities (90)
Dividends paid* (1,200)

Net cash used in financing activities (790)

Net increase in cash and cash equivalents 110

Cash and cash equivalents at beginning of period 120
Cash and cash equivalents at end of period 230

* This could also be shown as an operating cash flow.

Source: IAS 7 – Cash Flow Statements, Appendices

IAS 7 - INDIRECT METHOD (EXTRACT)
20X2
Cash flows from operating activities
Profit before taxation 3,350
Adjustments for:
Depreciation 450
Foreign exchange loss 40
Investment income (500)
Interest expense 400
3,740
Increase in trade and other receivables (500)
Decrease in inventories 1,050
Decrease in trade payables (1,740)
Cash generated from operations 2,550
Interest paid (270)
Income taxes paid (900)

Net cash from operating activities 1,380

Cash flows from investing activities

Acquisition of subsidiary X net of cash acquired (550)
Purchase of property, plant and equipment (350)
Proceeds from sale of equipment 20
Interest received 200
Dividends received 200

Net cash used in investing activities (480)

Cash flows from financing activities

Proceeds from issue of share capital 250
Proceeds from long-term borrowings 250
Payment of finance lease liabilities (90)
Dividends paid* (1,200)

Net cash used in financing activities (790)

Net increase in cash and cash equivalents 110

Cash and cash equivalents at beginning of period 120
Cash and cash equivalents at end of period 230

* This could also be shown as an operating cash flow.

Source: IAS 7 – Cash Flow Statements, Appendices
IAS 7 - INDIRECT METHOD (EXTRACT)
20X2
Cash flows from operating activities
Profit before taxation 3,350
Adjustments for:
Depreciation 450
Foreign exchange loss 40
Investment income (500)
Interest expense 400
3,740
Increase in trade and other receivables (500)
Decrease in inventories 1,050
Decrease in trade payables (1,740)
Cash generated from operations 2,550
Interest paid (270)
Income taxes paid (900)

Net cash from operating activities 1,380

Source: IAS 7 – Cash Flow Statements, Appendices

IAS 7 - INDIRECT METHOD (EXTRACT – CONT.)
20X2
Cash flows from investing activities
Acquisition of subsidiary X net of cash acquired (550)
Purchase of property, plant and equipment (350)
Proceeds from sale of equipment 20
Interest received 200
Dividends received 200

Net cash used in investing activities (480)

Cash flows from financing activities

Proceeds from issue of share capital 250
Proceeds from long-term borrowings 250
Payment of finance lease liabilities (90)
Dividends paid* (1,200)

Net cash used in financing activities (790)

Net increase in cash and cash equivalents 110

Cash and cash equivalents at beginning of period 120
Cash and cash equivalents at end of period 230

* This could also be shown as an operating cash flow.

Source: IAS 7 – Cash Flow Statements, Appendices
 STATEMENT OF CASH FLOWS RATIOS
CASH FLOW MEASURES
RELATED TO RETURN

A ratio that is useful in determining a

company’s ability to pay dividends, and over
time, how successful their operations are is
Cash Flow per Share, computed as follows:
(Net cash provided by operations -
Cash Flow Dividends on preferred stock)
per Share = --------------------------------------------
Common shares outstanding
CASH FLOW MEASURES
RELATED TO RETURN

Another cash measure of return is the ratio of Cash Flow to

Total Assets, which provides a measure of cash return on
the investment and can be used over time as a measure of
profitability. It is computed as follows:

Cash Flow Cash flow from operations

to Total = --------------------------------------------
Assets Average total assets
CASH FLOW MEASURES
RELATED TO RETURN

One other measure of return that is discussed by analysts

is Free Cash Flow. This measure indicates the amount of
cash that is generated by operations, after maintaining
productive capacity. It is computed as follows:

Cash invested
Free Cash Flow = Cash generated -- to maintain
from operations
capacity
CASH FLOW MEASURES
RELATED TO SAFETY

Cash flow measures related to safety have to do with how

cash flows from operations compare with some required or
anticipated payment. One such measure is the ratio of
Dividends to Operating Cash Flow, calculated as follows:

Dividends to Current dividends paid

Operating Cash = ----------------------------------
Flow Cash provided by operations
CASH FLOW MEASURES
RELATED TO SAFETY

Another measure of safety is the ratio of Cash Flow to

Current Maturities of Debt. This ratio indicates a
company’s ability to generate enough cash from its
operations to repay debt commitments that mature in the
near future, excluding normal trade payables. It is
calculated as:

Cash provided by operations

Cash Flow to
Maturing Debt = ----------------------------------------
Debt maturing currently
CASH FLOW MEASURES
RELATED TO SAFETY

A similar measure of safety is the ratio of Cash Flow to

Total Debt. This ratio takes a longer-run view by comparing
current cash flow from operations with total liabilities. The
higher the ratio, the better a company’s debt-paying ability
and the better the safety margin for creditors. It is
calculated as follows:

Cash provided by operations

Cash Flow to
Total Debt = ----------------------------------------
Total debt
 KEY LEARNING POINTS

 Financial analysis, though varying according to the particular

interests of the analyst, always involves the use of various
financial statements – primarily the balance sheet and income
statement.

 The balance sheet summarizes the assets, liabilities, and

owners’ equity of a business at a point in time, and the income
statement summarizes revenues and expenses of a firm over a
particular period of time.

 International and national accounting standard setters, are

working toward “convergence” in accounting standards around
the world. “Convergence” aims to narrow or remove accounting
differences so that investors can better understand financial
statements prepared under different accounting frameworks.
 A conceptual framework for financial analysis provides the
analyst with an interlocking means for structuring the analysis.
For example, in the analysis of external financing, one is
concerned with the firm’s funds needs, its financial condition
and performance, and its business risk. Upon analysis of these
factors, one is able to determine the firm’s financing needs and
to negotiate with outside suppliers of capital.

 Financial ratios are the tools used to analyze financial condition

and performance. We calculate ratios because in this way we
get a comparison that may prove more useful than the raw
numbers by themselves. International and national accounting
standard setters, are working toward “convergence” in
accounting standards around the world. “Convergence” aim to
narrow or remove accounting differences so that investors can
better understand financial statements prepared under different
accounting frameworks.
 Financial ratios can be divided into five basic types: liquidity,
leverage (debt), coverage, activity, and profitability. No one ratio
is itself sufficient for realistic assessment of the financial
condition and performance of a firm. With a group of ratios,
however, reasonable judgments can be made. The number of
key ratios needed for this purpose is not particularly large –
about a dozen or so.

 The usefulness of ratios depends on the ingenuity and

experience of the financial analyst who employs them. By
themselves, financial ratios are fairly meaningless; they must
be analyzed on a comparative basis. Comparing one company
with similar companies and industry standards over time is
crucial. Such a comparison uncovers leading clues in
evaluating changes and trends in the firm’s financial condition
and profitability. This comparison may be historical, but it may
also include an analysis of the future based on projected
financial statements.
 Additional insights can be gained by common-size and index
analysis. In the former, we express the various balance sheet
items as a percentage of total assets and the income statement
items as a percentage of net sales. In the latter, balance sheet
and income statement items are expressed as an index relative
to an initial base year.